Thursday, June 6, 2013

Rubbernecking Delays in Stamford: Waiting on SAC Capital

Rubbernecking Delays in Stamford: Waiting on SAC Capital

I haven’t driven along Shore Road in Stamford, Connecticut in several years.  But I can imagine there are rubber necking delays as the two-lane road passes near the headquarters of SAC Capital Advisors.  Town cars are probably trolling up and down the road as Wall Street brokers peer out the window to see if they can detect any sudden activity at the notorious hedge fund.

The financial press has been reporting that Wall Street brokers are closely watching for the outcome of the SAC saga.  Will Stephen A. Cohen be indicted by the US Department of Justice?  Will the remaining outside investors withdraw all of their capital?   Why does SAC Capital hold such special fascination for Wall Street?
West Coast Needs (1999)
For well over a decade, SAC has been a wildly profitable client to Wall Street, which gives us the opportunity to look at the relationship between hedge funds and the Street. The most obvious source of profits comes from trading.  SAC is an active event driven manager, which means the hedge fund is looking to take positions in a companies that are about to face an incident or catalyst that will move their stock prices.  Thus, they are hunting for product announcements, sales forecasts, mergers, divestitures, or any other story that will quickly shift prices.  In addition to owning stock, SAC may decide to use options or futures to take a position.  Moreover, if the anticipated event is negative, SAC will want to short stock or buy puts.  SAC isn’t required to reveal its trading volume, but it’s safe to assume that they generate huge amounts of activity, which means lots of commissions and trading profits for Wall Street.  I’m sure many Wall Street traders have put on the same trade as SAC when they’ve learned that Mr. Cohen or one of his portfolio managers was building a position.

As I just mentioned, SAC will take short positions to try to take advantage of potentially negative news.  Shorting stocks requires SAC or any other investor to borrow stock, which is another source of profit for Wall Street, as they earn fees and interest on the short positions.

In recent months the spate of IPOs and secondaries has also been a major source of profit for Wall Street.   I’d expect that SAC Capital has been a huge consumer of these offerings, which offer brokers particularly large commissions.  Moreover, SAC has probably represented a substantial part of the trading volume of these issues in the days after these securities come to the market.

SAC manages about $15 billion, but they magnify their buying power and influence by borrowing about $2 for every dollar they manage.  As a result, they have roughly $45 billion of capital looking for ideas to trade on.  Thus, the amount of commissions is greatly magnified, and the Street earns interest and fees on the loans used to leverage the fund.  In addition, Wall Street’s profits are augmented by fees generated by custody, record-keeping, and other services.

In an era where high frequency trading is coming to dominate the market and in many instances by-pass traditional Wall Street firms, SAC Capital has been increasingly important to the Street.  You may be thinking that SAC’s demise won’t really be that bad for Wall Street.  Even if SAC Capital loses all its outside capital, they’ll still have Mr. Cohen’s $9 billion fortune to manage.  Moreover, the outside investors will have to put their money someplace else where Wall Street can profit.  There’s a degree of truth in both these statements.

However, if Mr. Cohen is left to manage the family fortune, it will be less lucrative to Wall Street.  The New York Times suggests that Mr. Cohen would use less leverage if he were only managing his own money.[1]  Without the fees and carry from investors as a cushion, Mr. Cohen might become a bit more conservative.  It’s funny how money managers will take more risk when they’re managing someone else’s money.
As for the outside investors, they will probably put the money back into hedge funds, but it will probably not be in strategies that are as profitable as the style employed by SAC Capital.

So Wall Street is carefully watching the Justice Department probe of SAC Capital because it may severely wound a highly prized client.  The Street should have broader concerns.  SAC Capital isn’t the only firm that fished close to, or perhaps, in the waters that are insider trading.  Many hedge funds and the proprietary desks of Wall Street firms have been involved in similar expeditions.    Insider trading is like shooting fish in a barrel.  Perhaps the Justice Department will take the barrel away, which will make fishing a lot less profitable.


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